Knowing how much to pay for a business is a big part of your success in buying an existing business. If you pay too much you may not have the money you need to invest in your business later on and make it grow. If you low-ball sellers, you may never close a transaction. If that happens, you’ll never fulfill your dream to become self-employed. So how do you determine a fair price?
Fortunately, it’s not as difficult as you might think. There is only one question you need to answer; what is the business worth to you. Later on you’ll focus on what the company is worth to the seller. But for now, focus on yourself.
(Your seller may or may not be willing to sell the business to you for what you are willing to pay, and that’s fine. But your mission is to drill down to get your number and not worry about much else. If it’s right it’s right. If it isn’t there will be other opportunities.)
What is the right price for you to pay?
In order to determine what you should pay for a business, you have to first get a sense of what your net income will be. Again, net income is very much a function of your unique circumstances as a small business owner. Do you any special skills or experience that will add value (and net income to the bottom line)? Do you see opportunities to really make this thing fly? Do you have the ability to turn that vision into reality? If so, the company is worth more to you. Great. But let’s also consider the other alternative.
If you are you a complete novice you will have to bring in other experts to run the show thus adding more cost and making the firm less profitable. That drops the value proposition.
Create an income statement for each of the next 5 years based on your cost and sales assumptions. Take the seller’s existing profit and loss statement and tweak it to reflect what it will look like when you take over. This is what’s called a “pro forma”. If you don’t feel qualified to do this, talk to a good CPA and have her create these statements for you. It’s worth a few hundred bucks to have this done right.
Your next step is determining the “multiple” for this particular business. You take the net earning or gross sales (depending on the industry) and multiply that figure by the “multiple”. Then you make adjustments for inventory and other assets. You can do some hunting on the net or you can speak to a business broker to get a sense of what the multiple is for your particular industry.
Let’s say you are buying an auto repair shop. According the New York Times, the “multiple” is 40% of annual sales plus inventory. So if the shop has annual sales of $300,000 and $100,000 in inventory, the business is worth around $220,000. But you aren’t even close to making an offer yet.
Before you speak to your seller, think about what is going to happen to sales over the next several years. Are you sure you’ll be able to grow those sales? If so, the business is worth more to you. Are you clueless about growth? That being the case, you take a risk when you buy the business because there is no guarantee that those sales will continue. As a result, you can’t offer as much.
If you are keen to buy a business but don’t have the cash, it may be sign from above that you should consider other lower-cost alternatives. However, if you are absolutely convinced that this is the way to go, please don’t lean on your credit card. There are better financing alternatives to credit card debt.
Your next consideration is momentum. Look at the tax returns and financial statements. If sales are increasing, find out why. Will you be able to keep that positive direction going? If sales are declining, find out why. Can you turn it around? If not, you might be making a big mistake. I suggest you look for another opportunity.
At this point, you have a great deal of information. You know what the business is worth to you. You know what your risks and opportunities are. And you also know what the business is worth to the seller. At this point, get the seller to present the first number.
If the business is on a huge growth track but the seller is highly motivated to sell the business fast, it might be a great deal to pay her the multiple on current sales plus inventory. Even if she asks a bit more, it could still be a good deal if you are sure you’ll be able to capitalize and continue that growth.
If on the hand sales are declining it’s a different story. Discuss the multiple that is generally acceptable but make an offer based on what sales are going to look like over the next 5 years if the current decline continues. Of course the business is worth much more to you because you are going to turn that around (if that’s not the case please don’t buy this business). But there is no certainty that you’ll be able to actually turn this sow’s ear into a silk purse so make sure the price is reduced to reflect your risk.
I am a huge fan of being self-employed. The financial rewards can be far greater than working for “the man”. And the potential for freedom and sense of accomplishment that are available by running your own shop are simply priceless. If you want the benefits of being a successful small business owner, get off on the right foot by paying a fair price for your enterprise.
Have you ever purchased a business in the past? How did you determine a fair price?
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